Inflation and Value Investing

Recent news has been filled with reports about rising inflation.  Whether you’re paying attention to economic statistics or not, I’m sure many of us will have noticed the prices rise on our weekly food shops or when filling up the car (even if it is electric).

We could debate for hours about whether inflation is transitory, whether inflation has peaked and what long term inflation predictions may be, but we would prefer to ponder on what investments could outperform in an inflationary environment.

In many of the meetings I have had with clients so far this year, one of the key questions has been; “What investments perform well during inflationary periods?”

Historical data seems to show that value investing strategies have outperformed growth strategies, on average, during inflationary periods.

The positive relationship between value investing and inflation can be validated as far back as the 1920s.  This can be seen in the following chart:

Source:  Euclidean Technologies; as at October 2021

The inspiration for the chart came from a similar chart posted by William Bernstein in the early 2000’s on his website Efficient Frontier.

From this graph, I believe it can be inferred that value investing tends to outperform during periods of high inflation.

Why does this relationship exist?

To understand the answer to this question, we must recognize that the opposite approach to value investing is growth investing.  Growth investing values companies based on their future expected earnings, as opposed to their past or present earnings.  Furthermore, inflation, by definition, is the process by which money in the future becomes less valuable in the present.  Therefore, in higher inflation periods, future earnings become less valuable and current earnings become correspondingly more valuable.  Since “value stocks” are valued on their near-term earnings, it follows that inflationary periods should be better for value stocks than for growth stocks and vice versa.

With inflation hitting multi-decade highs across the US, UK and other developed markets, we may be entering a period where value investing outperforms growth investing – a shift from what has transpired over the past several years.

As an example, using recent data relating to the S&P 500 for the year-to-date, the expectation of value outperforming growth in an inflationary environment has been vindicated within the S&P 500, the world’s largest market.

The chart below shows the relative performance of value versus the S&P 500 and growth versus the S&P 500.  As can be seen, so far this year, value is outperforming the S&P 500 and also significantly outperforming growth.

Source:  Koyfin; as at 26th April 2022

The example only shows the results for one market for one year and results may vary over longer time periods and different markets.

Of course, we cannot be certain that the out performance of value investing in an inflationary environment will continue but it’s important to be aware of this potential turning of the tide.

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